Federal Debt and the Risk of a Fiscal Crisis

Persistent deficits and mounting debt could have negative economic consequences for the U.S.

Over the past few years, U.S. government debt held by the public has grown rapidly—to the point that, compared with
the total output of the economy, it is now higher than it has ever been except during the period around World War II.

The recent increase in debt has been the result of three sets of factors: an imbalance between federal revenues and spending
that predates the recession and the recent turmoil in financial markets, sharply lower revenues and elevated spending that
derive directly from those economic conditions, and the costs of various federal policies implemented in response to the conditions.

Further increases in federal debt relative to the nation’s output (gross domestic product, or GDP) almost certainly
lie ahead if current policies remain in place. The aging of the population and rising costs for health care will push federal
spending, measured as a percentage of GDP, well above the levels experienced in recent decades. Unless policymakers restrain
the growth of spending, increase revenues significantly as a share of GDP, or adopt some combination of those two approaches,
growing budget deficits will cause debt to rise to unsupportable levels.

Although deficits during or shortly after a recession generally hasten economic recovery, persistent deficits and continually
mounting debt would have several negative economic consequences for the U.S.

Some of those consequences would arise gradually: A growing portion of people’s savings would go to purchase government
debt rather than toward investments in productive capital goods such as factories and computers; that “crowding out”
of investment would lead to lower output and incomes than would otherwise occur.

In addition, if the payment of interest on the extra debt was financed by imposing higher marginal tax rates, those rates
would discourage work and saving and further reduce output. Rising interest costs might also force reductions in spending
on important government programs. Moreover, rising debt would increasingly restrict the ability of policymakers to use fiscal
policy to respond to unexpected challenges, such as economic downturns or international crises.

Beyond those gradual consequences, a growing level of federal debt would also increase the probability of a sudden fiscal
crisis, during which investors would lose confidence in the government’s ability to manage its budget, and the government
would thereby lose its ability to borrow at affordable rates.

It is possible that interest rates would rise gradually as investors’ confidence declined, giving legislators advance
warning of the worsening situation and sufficient time to make policy choices that could avert a crisis. But as other countries’
experiences show, it is also possible that investors would lose confidence abruptly and interest rates on government debt
would rise sharply.

The exact point at which such a crisis might occur for the U.S. is unknown, in part because the ratio of federal debt to
GDP is climbing into unfamiliar territory and in part because the risk of a crisis is influenced by a number of other factors,
including the government’s long-term budget outlook, its near-term borrowing needs, and the health of the economy. When
fiscal crises do occur, they often happen during an economic downturn, which amplifies the difficulties of adjusting fiscal
policy in response.

If the U.S. encountered a fiscal crisis, the abrupt rise in interest rates would reflect investors’ fears that the
government would renege on the terms of its existing debt or that it would increase the supply of money to finance its activities
or pay creditors and thereby boost inflation. To restore investors’ confidence, policymakers would probably need to
enact spending cuts or tax increases more drastic and painful than those that would have been necessary had the adjustments
come sooner.

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